Saturday, 20 December 2014

Monetary Impotence in context

Mainly for macroeconomists

There are a significant group of people who think that monetary
policy must be the right answer even in a liquidity trap because of the centrality of money in
macroeconomics, and because of ‘basic’ ideas like money neutrality. Call them
market monetarists if you like. They dislike fiscal stimulus because - in their
view - it just has to be second best, or a fudge, compared to monetary policy.
Their view is not ideological, but essentially based on macro theory. Now it
may not be very relevant to the real world, but for many holding the theoretical
high ground is important, because it colours their view of the real world.

That is the group that Paul Krugman has been arguing with
recently, and why the point he made in his post yesterday is so critical. It is set in an
idealised two period world where Ricardian Equivalence holds, but that is entirely appropriate for the
task in hand. If people believe something because of (in their view) basic
theory, and you think they are wrong in terms of basic theory, then that is the
level on which to argue.

The argument is that in a liquidity trap, when prices are
sticky, temporarily expanding the money supply - even if it involves helicopter money (i.e. money financed tax cuts)
- will not do anything to get you out of the trap. Another, and more modern,
way of saying the money supply increase is temporary is saying that the
inflation target is unchanged, so the long run price level is unchanged. (Long
run money neutrality does hold in this world.) I will not go through Paul’s
argument in detail - I have gone through the same logic before. The basic point is that the temporary
increase in money is saved, not spent, because agents know it is temporary.
Short run money neutrality does not hold, and not because prices are sticky,
but because of Ricardian Equivalence.

It is exactly the same reason why the Pigou effect is no longer
discussed. Ricardian Equivalence killed the Pigou effect as a fundamental
theoretical idea. If the inflation target is unchanged, when prices fall today
the future price level must fall pari passu, reducing the future nominal stock
of money. There is no wealth effect. As I noted here, even allowing money to be special in not
being redeemable does not get the Pigou effect back, because with irredeemable
money any wealth effect comes from the long run stock of money.

Money is not a hot potato in this world. The potato has gone
cold because of the liquidity trap, and the money is happily saved to pay the
future tax increases that will be required to keep the long run money stock
(and price level) constant.

While in this largely frictionless world money is impotent,
additional government spending is a foolproof way of expanding demand. So is
raising the long run price level, which means at some point raising the
inflation target.

All I really wanted to do in this post was make an observation.
The theoretical point that Paul makes depends crucially on thinking in an
intertemporal manner, which gives you Ricardian Equivalence. Just as price
rigidity kills short run monetary neutrality, so does Ricardian Equivalence in
an inflation targeting liquidity trap world. So here is modern microfounded
macroeconomic theory providing support to increasing government spending rather than monetary policy in
a liquidity trap. Modern theory is not inherently anti-Keynesian. .

48 comments:

Isn't this argument the basis for the "market" in market monetarism? They look to wage growth and nominal gdp as adjustments to anticipated money supply paths. Paul Krugman seems to argue against the political feasability of overshooting nominal targets to credibly establish money base expectations. But is he arguing that the Fed must persistently demonstrate "irresponsibility" in order to achieve credibility, or is this reasoning specific to the current climate?

Would any market monetarist disagree with this post? "Paul Krugman and I both use a similar framework to analyze monetary policy. Temporary monetary injections don’t have much effect; stimulus comes from injections that are expected to be permanent."--Scott Sumner http://www.themoneyillusion.com/?p=9627

So why do they complain so much, in a world in which inflation targets exist, about the use of fiscal stimulus? Why are they not - in a world where inflation targets exist - complaining about widespread austerity? Why do I keep being told in comments that the US recovery proves fiscal policy does not matter. Why do some, at least, still seem to deny the importance of the zero lower bound for interest rates?

"So why do they complain so much, in a world in which inflation targets exist, about the use of fiscal stimulus? Why are they not - in a world where inflation targets exist - complaining about widespread austerity?"

Because like Krugman 1998 and Eggertsson and Woodford 2003, they think inflation targets should not exist. And it seems weird to them to argue that instead of making a fairly straightforward change to current central bank practice (level instead of growth rate targeting), we should look to discretionary fiscal stimulus that leaves us more indebted and creates opportunities for corruption and waste. Also Sumner's dubious argument that the situation in the US would have been so dire without fiscal stimulus that Bernanke circa 2008 would have done what Bernanke circa 2003 said he should and we'd all be better off.

There is little disagreement about economics, at least economic theory. There is little disagreement that more AD would be a good thing. The disagreement is whether macroeconomists should push central bankers to adopt what most agree is optimal policy, or instead push politicians to adopt a second-best.

"Why do I keep being told in comments that the US recovery proves fiscal policy does not matter."

Because substantial austerity plus reaffirmed Fed commitment to maintaining a steady pace of growth in 2013 led to...a steady pace of growth. Maybe something else offset all that austerity, but as far as I know the Keynesians haven't said what. And since the Fed seems entirely comfortable with the pace of recovery, they guess that more fiscal stimulus would just mean even tighter monetary policy, so what's the point? (Though some acknowledge that the Fed's preferences seem pretty weird and that they might be comfortable with more growth/inflation as long as no one's saying that monetary policy is what caused it. But that annoys them very much.)

"Why do some, at least, still seem to deny the importance of the zero lower bound for interest rates?"

They don't deny that it's important, but argue that needn't be. Most see the problems associated with the ZLB as a consequence of CBs' weird preference for communicating using short-term interest rates. They say interest rate targeting is a steering wheel that works great until you're about to drive off a cliff, or something. Why not just get a different steering wheel? Did the ZLB stop FDR from bringing about the fastest peacetime growth in US history?

Not trying to speak for Scott...but he often points to how strongly stock markets react to any slight perceived change in monetary policy, contrasted with the non-existent responses to changes in fiscal policy.

In other words, market monetarists don't talk much about the effects of fiscal policy because they are ideologically predisposed not to like fiscal policy.

This extends to discussions about the reality of monetary policy in world of central banks who aren't market monetarists. These central banks don't appear to have coherent reaction functions beyond inflation targets they frequently miss.

So instead market monetarists talk about how none of that would matter if only people adopted NGDP, though somehow they still manage to claim every empirical result is an affirmation of market monetarism even when its anything but clear what kind of explicit level targeting central banks actually use. We hear above, for example, that the US's weak growth is somehow an affirmation of market monetarism, despite the existence of a sustained large output gap, because ... tautologically, according to MM, whatever growth rate the Fed achieved is what they set out to achieve!

I'll add though, I do think the OP's point, that Sumner and Krugman has similar analytical frameworks on this, is spot on. It's all about expectations, at the zero bound at least. And AA describes well some of the caveats (though most MMers manage to forget them in discussions of fiscal policy).

"tautologically, according to MM, whatever growth rate the Fed achieved is what they set out to achieve!"

One does get this feeling from a lot of what MM's say. But for the US at least, MM's (along with most financial sector economists and private forecasters) seem to think that the Fed is achieving its goals on inflation mostly because the Fed says it's achieving its goals on inflation. And when it's looked like inflation would fall below what the Fed was comfortable with, they've acted. If you look at the FOMC's projections (which are their view of outcomes under "appropriate monetary policy") they've been very close on inflation at a one-year horizon, and have regularly revised down their view of productivity/potential to explain their errors on output growth.

It's just very hard to look at the Fed winding down QE and planning for rate hikes in the next few months and say "really though what they want is a hotter economy." A key phrase for me in recent statements is "maximum employment in a context of price stability" (though they appear to have dropped it in December, perhaps after someone pointed out it's borderline violation of the FRA). They claim they've got more ammunition but don't feel like the outlook calls for further action. It sure seems like they're achieving what they set out to achieve. The problem is that they've set out to achieve a disaster.

Is it acceptable to suppose that households are forward looking and thus expect that the nominal interest rate will increase in the future? This assumption is the basis of liquidity trap.

For example, in the Eurozone, I doubt that households ever think about an increasing of the future interest rate. Thus, is the so-called "liquidity trap" only a theoretical argument? Because if it is, it means that a monetary policy still could have an impact on the Eurozone today.

Good point. For every 100 economists who refer to the Ricardian effect, only about one refers to ACTUAL EVIDENCE as to whether the Ricardian effect is of any significance, far as I can see. Joseph Stiglitz described Ricardian equivalence as “pure nonsense”.

The evidence seems to be that Stiglitz went a bit far: i.e. the effect does exist. But as you rightly suggest, an awful lot of households (and indeed firms) do not think or plan in a Ricardian way.

As Bill Mitchell said "When was the last time you saved up to pay for future tax increases? Another failed neo-liberal theory." The Pigou Wealth Affect and The Ricardian Equivalence Affect, have never been proved to work in any measurable fashion.

Mitchell (and the MMT School since), further commented. "When Barro released his paper (late 1970s) there was a torrent of empirical work examining its predictive capacity. It was opportune that about that time the US Congress gave out large tax cuts (in August 1981) and this provided the first real world experiment possible of the Barro conjecture. The US was mired in recession and it was decided to introduce a stimulus. The tax cuts were legislated to be operational over 1982-84 to boost aggregate demand.

Consistent with the Ricardian Equivalence theorem, the proponents of Barro’s ideas all predicted that saving would rise to pay for the so-called ‘future tax burden’ which was implied by the rise in public debt at the time (associated with the rising deficit). What happened? If you examine the US data you will see categorically that the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84). In other words, Ricardian Equivalence models got it exactly wrong."

Mitchell added. "In recent policy debate, the concept has been used by austerity proponents, to justify their so-called ‘fiscal contraction expansion’ claim. Accordingly, the ‘Ricardian’ effects are alleged to be reversed once fiscal austerity is imposed and governments cut deficits. Because consumers and investors will realise that tax rates will not have to rise and, consequently, will increase their spending and more than offset the loss of government spending."

Five years of "austerity" has conclusively proved to me, that Ricardian equivalence with added Pigou, doesn't work forwards or backwards.

When a few years ago a sample of Danish voters was asked if the government was running a surplus or a deficit, two-thirds said they didn't know. Hard to see them saving (spending) their tax cuts (increases) isn't it?

As someone who spent the last fifteen years in market research, the notion of Ricardian Equivalence as applied to consumers seems not just dubious, but hilarious. Has anyone seen this beast in the flesh? I don't mean imputed using macroceconomic measures, but actual consumer behavior via tax documents or household spending panels or the like. Even simulation experiments with consumers? Just wondering...

"An immediate implication is that the current money supply doesn’t matter. The future money supply matters, because it can affect the future price level, so a permanent increase in M can affect the economy — but that effect works entirely through expectations."

Either fiscal or monetary policy or a combo can effect the future price level. Isn't this what happened in New Zealand?

1. OK. Now I get your larger point. If the market monetarists are not going to get their preferred policy of NGDP-path targeting (or price-level targeting or even higher inflation targets), they should support the next best policy, which is fiscal stimulus.2. As you know, some of them find fiscal stimulus distasteful for philosophical reasons. They don't like big government. (They might be more sympathetic to tax cuts than to spending increases.) 3. But in a world where the central bank is consistently undershooting its inflation target--as the Fed has done--the market monetarists still have a lot to play for, even if the target remains unchanged. A monetary expansion sufficient to achieve 2% US inflation immediately (and forever after) leaves the price level permanently higher (and therefore the money supply permanently bigger) at all future dates than an expansion sufficient to achieve 2% inflation some time in 2016 (the Fed's central projection). 4. If, on the other hand, the central bank is already hitting its inflation target, then fiscal expansion won't help, because the central bank will act to offset its stimulative effect.5. So in a world where inflation targets exist, the central bank is either hitting its target, in which case fiscal stimulus will be offset, or it is undershooting its target. If it is undershooting, then more decisive monetary policy can indeed raise the money supply and price level permanently.That, at least, is how I understand their argument.

Though I would love it for a market monetarist to actually acknoweldge: in a world where central banks make and hit inflation targets, or even NGDPLTs, fiscal policy would *still not be entirely offset* in its effect on real GDP.

It bugs me that they seem to fudge from the observation that monetary policy partially offsets fiscal policy to the claim that fiscal policy doesn't matter, doesn't work, has a zero multiplier, or other incorrect statements.

Do you mean because of supply-side effects? MM's definitely acknowledge that. Sumner for example often advocates payroll tax cuts as a complement to monetary stimulus. It does get fudged in a lot of the discussion, because blogs, but Sumner has clarified a few times that he means the demand (nominal GDP) multiplier is zero, and that this is an empirical judgment about the Fed's reaction function.

Simon,Thanks for replying. I'm obviously missing something, and the onus is on me to figure out what it is. But let me restate my confusion anyway.

1. QE that is temporary does not work. I get that. 2. If the inflation target is unchanged, QE is ipso facto temporary, because the long run price level is unchanged. It seems to me that is only true if the central bank is in fact actually hitting its inflation target. In the US, that's not yet the case.Suppose today's price level is 100. The central bank targets 2% inflation. But for whatever reason it expects to undershoot its target for a year. Then next year's price level might be 101.3. The 2016 price level might be 2% higher than that (103.326) and so on.More QE might allow the central bank to hit its target next year. The 2015 price level would then be 102, rising to 104.4 in 2016. The price level is on a permanently higher path. As is the money supply. The QE required to reach a price level of 104.4 in 2016 is, in that sense, permanent. It should therefore be effective.

ST's point that fiscal stimulus might yield the same NGDP but with higher real GDP (and lower prices) is interesting. It hadn't occurred to me before.

The argument made by PK and SWL is that (in this simplistic model), QE that is limited to the present period does not have any direct effect on inflation in this period. The only way the central bank can increase inflation today is by creating an expectation of increased inflation tomorrow. Because consumers know their money will be worth less tomorrow (inflation), they consume more today, thus generating both inflation and economic growth. In short, it's all about expectations.

To add to Anonymous, I think the argument is that there might not be a price level path (without huge amount of possibly inefficient fiscal stimulation), which gets us to 2% inflation target without temporarily passing through a higher inflation rate.

The NGDPLT path solves this problem, as would probably just a higher price level path (but maybe not as theoretically efficiently). Doing fiscal stimulation will probably work also but it might be much less efficient and if the conditions are not right, monetary offset will mean people are left with more debt and little to show for it.

The truth is probably somewhere in between the monetarist and Keynesian position but Krugman discounts way too much the importance of the monetary expectation channel.

''Because consumers know their money will be worth less tomorrow (inflation), they consume more today''

any empirical evidence for this or is this just theory?If I knew my money would be worth less tomorrow, I would adjust my spending pattern downwards and save more. Unless inflation would be double digits, than I would shop like the Russians this week, but I don't expect any economists to be in favor of this.

I suppose I should've clarified that further but I didn't want to make my comment too long.

Think of a household that believes inflation is going to be 4% rather than 2% in the next period (the next year, say). If its breadwinners were earning fair wages before the change, it will have no effect on their real wages and only a small effect on their wealth. The higher inflation does however increase the cost of holding on to money (cash and non-interest earning bank deposits). It creates incentives for the household to consume more durable goods (cars, refrigerators etc) and to put more money into interest bearing saving accounts. A large part of the latter will be lent out by the bank to finance investments which increases inflation and growth.

Another important effect is on the behaviour of companies. A big problem during the years since the crisis is that companies have been hoarding cash. If expected inflation in the next period increased, the cost of doing this rises and at least some of that money will be spent on investments. This also increases inflation today.

@Hugo: Thanks for the explanation, but I'm not sure whether that addresses Anon's point. The issue is that the Krugman-SWL story seems to assume that without QE/additional monetary accommodation we will have inflation of 2%. Then QE will be effective only to the extent that it is permanent, thus leading private agents to expect inflation to overshoot this 2% target (whence the mechanisms you're explaining kick in). However, to me it seems that atm nobody believes the ECB, say, is going to achieve its 2% target without QE (as, for instance, the 5y5y-forward curve demonstrates for "Mr Market"). Were the ECB to implement full-blown QE, then this would likely raise inflation expectations even if the increase in the money supply is only temporary (eg by lowering long-term rates and hence the cost of borrowing for investment). Where's my mistake?

A different point which I don't understand is the following. Krugman's 2-period model assumes that r=0, but isn't one fundamental aspect of QE to reduce interest rate*s*, a channel which the model assumes away by setting a single r=0?

Give over with this liquidity trap myth and its supposed connection to inflation; interest rates; money supply etc. Have a read of http://bilbo.economicoutlook.net/blog/?p=22149 . "Keep the helicopters on their pads and just spend".

I thought this was a great , clarifying article even for non-macroeconomists.

As long as you have the assumption that everyone thinks the inflation target .will be hit I think that Ricardian equivalence kicks in and renders monetary policy in a liquidity trap impotent. This may well have been a good assumption in Japan in 1998 when Krugman developed his model.

But isn't one of the main points of Market Monetarism that this assumption should be undermined by the CB setting expectations that an NGDP target will be hit no matter what this does to inflation ? A CB that committed to NGDPT could make monetary policy work by promising to be responsible now and in the future.

Your last paragraph seems to get to the heart of the issue. If market monetarists were strict inflation-targeters, there may be (in this idealised hypothetical world under consideration, in which the departures from reality are central to the conclusion) a problem for market monetarists. However, market monetarists are not strict-inflation targeters, nor is almost any (or any at all?) central bank.

You don't know that inflation will increase in the future. Or at least you have no idea when it will increase (it might be ten years from now, for example).

All you know is that the central bank has promised to allow higher inflation in the future (if or when inflation occurs), or in other words it has promised to keep the interest rate low for longer than it normally would.

But if the central bank has no way to directly create inflation, then its promise to allow higher inflation in the future could have absolutely no effect.

Interesting. When you talk of fiscal stimulus, do you mean lower income or consumption taxes? Or something else? It isn't clear to me... and each has a different economic impact. As they say, the Devil is in the detail.

Fiscal stimulus in the U.S. is generally either an income tax cut (or credit), or a government spending program. In the U.S. at least, the federal government does not make much in consumption taxes, and so has little leverage there.

Fiscal stimulus is the currency issuer (Treasury) increasing the spending power of the currency users (private sector and the rest of the world) by increasing the net financial assets in the economy. The government can spend new money into existence by buying more goods and services available in the private sector. Or it could stop decreasing the spending power in the economy by reducing taxes. Both increase the budget deficit. Government spending is more effective because it gets into peoples wallets directly. Tax reductions are slower to take affect and are more likely to get saved or used to pay down debt.

The government's job is to maximise the use of the economy's resources, labour and capital, with a little bit of inflation to encourage more capacity to be built and productivity to rise. Unemployment and inflation accelerating, are the only two things the currency issuer has to worry about. Be it by its own spending or by commercial bank lending causing bubbles. Monetary policy operated by the central bank is supposed to control the latter but it is a sledgehammer to crack a nut. It does generate large bonuses for the casino City of London.

In a liquidity trap you are in a liquidity trap. Agreed. A major argument of Market Monetarism is that these phenomena only exist if an incompetent central bank creates them. Sometimes they appear but the associated collapse of GDP, employment and often a banking crisis brings the central bank to its senses - or the politicians take control of monetary policy and do the right thing.

They are as man-made as vacuums. Good for experiments and thinking about models, but not good for real life.

It's not quite true that "market monetarists" oppose fiscal policy. It is actually part of the way that non T-bill buying monetary policy works at the ZLB for T-bills during recessions. As central banks buy longer term assets in the effort to ensure that NGDP growth stays close to the CB's target growth rate for NGDP growth, rational governments see falling long term interest rates and begin to engage in investments whose net present values are positive at the lower interest rates (but were not positive at "normal" interest rates). This is fiscal stimulus. That few governments react rationally in this way is not the fault of market monetarists, but to deficit hawks, inflation bears, gold bugs, or other kinds of economic pests.

I think that what SWL is saying is that an expansion of the money supply to fund a tax cut in the first period would lead to a rise in prices in the second period and so agents would save in the first period to compensate for the loss from rising prices in the second period.

What still confuses me is why in this model the same would not apply to government spending, I think it relates to there being a higher long run price level if the government spends as there will always be a given amount of economic activity from this whereas 100% of a tax cut could be saved.

As a market-monetarist I don't see the point of disagreement here. In fact, the reason we have NGDP level target rather than a NGDP growth rate target is because we agree there has to be a permanent expansion of the monetary base. Maybe we haven't been clear enough on that point, but it is not for a lack of trying. See for example here.

I would also note, though, that this logic implies that fiscal policy should have little effect too if the inflation target does not change (since it implies no permanent change in the monetary base). It also means, though, if CBs are committed to these same inflation targets that fiscal austerity should little effect too. In other words, CBs are not committing to the permanent monetary base needed to raise inflation or the path of NGDP, but they are also not allowing the monetary base to decrease in a manner that would permanently push inflation below its target--an economic purgatory of sorts.

So monetary policy has no effect, but let's do it anyway. This is the problem with those who take themselves to be the Smartest Guys in the Room.

The Fed's balance sheet is massive and unparalled. Anyone more modest would say, "If we think it's not going to do any good, maybe we shouldn't do it, because it might have large unexpected consequences." But no, the Smartest Guys in the Room went to MIT and studied Economics and They Earned Nobel Prizes. So massive experimentation with the world's economy is part of their nature right.

Your definition of a helicopter drop is simply insufficient. By holding to your definition of a helicopter drop, which travels through the tax system, you increase the likelihood that Ricardian equivalence will significantly dampen the effect.

And Krugman's analysis does absolutely nothing to address a helicopter drop at all. I still consider everyone in the discussion to be perpetuating a mass fraud on the citizens of the world.

I have no reason to believe in Ricardian Equivalence, and neither do you. Regardless of ideology or politics, or what it's being used to promote, I can't think of any economic theory more obviously and immediately false than Ricardian equivalence.

Consumers can be trained after a constant, repeated experience of X to expect X in future - i.e. if you've lived through a lot of inflation, you'll expect inflation, and the reverse.

Ricardian equivalence, on the other hand, suggests that not only monetary but fiscal policy is totally impotent - all tax hikes become tax cuts later, and the reverse, and consumers *immediately* behave in reverse of the natural, immediate effects you'd expect from a loss or gain in income because they are more sensitive to the future, Circle of Life hypothetical rebalancing than they are to what's happening now.

It's a crowning absurdity. I think less of Simon for using it in an argument.

I never expected Keynesians to try and support their theories by appealing to Ricardian freaking Equivalence. I'm sure there must be a better way!

However, even more stunning is that while this is all dressed up as an argument against Market Monetarism, it isn't-

"While in this largely frictionless world money is impotent, additional government spending is a foolproof way of expanding demand. So is raising the long run price level, which means at some point raising the inflation target."

Obviously the second sentence is uncontroversially wrong, since you could raise the long run price level by raising the NGDP target or targeting some exchange rate etc. etc. However, the basic point is sound: if you raise the long-term price level, you can have monetary stimulus even at the ZLB. Great. Unfortunately, that's exactly what market monetarists have been saying! If the Keynesian argument is that "Monetary policy is impotent, unless (among other possibilities) you do what market monetarists recommend", then this is a case of violent agreement between people who should be on the same side of the overall debate!

"No case to answer", as far as I can tell. Market monetarism may be false, but it's not false because what it says is true, or because of Ricardian Equivalence.

"Just as price rigidity kills short run monetary neutrality, so does Ricardian Equivalence in an inflation targeting liquidity trap world. So here is modern microfounded macroeconomic theory providing support to increasing government spending rather than monetary policy in a liquidity trap."

- seems like a complete non-sequitur to me, even if we grant Ricardian Equivalence, but I may have misunderstood. The second sentence is entirely logically separate from the first.

I'm not an economist. That said, I think your post affirms in theory what I've been thinking for the past couple years, namely that in a liquidity-trap, inflation-targetting, fiscal stimulus-constrained world, the policy solution is to credibly raise the CB inflation target from, say, 2% to 4%. In this environment it appears the 2% target is too low - why is it taking so long for policy makers to figure this out? What's sacred about 2%?

The big banks with access to the discount window have really, really weird lending policies - seemingly designed not to lend to creditworthy projects, but to extract a flow of fees. Creditworthy projects can't get loans, but people who are hopelessly underwater in debt often can, as long as the fees can be extracted. This debt slavery business model leads to complex and bad results. Just like in the situation with irresponsible consumers and payday loans in UK.

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